Material participation sits at the heart of many powerful tax strategies. Whether you’re running a small business, flipping houses, managing a short-term rental, or launching a new venture, your ability to deduct losses often hinges on whether you spent enough hours to “materially participate” for the year.
In most cases, taxpayers need to pass one of the seven material participation tests — commonly by working more than 100 hours, and no one else works more; or more than 500 hours during the year. (We’ve a complete list of the seven tests here: Counting and Grouping Material Participation Hours.)
If you meet one of these tests, you materially participate. If you don’t, the activity is passive — and passive losses often get suspended.
A Simple Example Makes This Clear
Let’s look at a simple example. Say Tom and Dick each start new businesses in 2025. Both generate a $100,000 loss.
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Tom materially participates → he can probably deduct the loss.
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Dick does not materially participate → his loss is likely suspended under the passive activity rules.
So far, nothing surprising. But buried inside this area of the law is a question many professionals get wrong:
When do you start counting hours toward material participation?
Let’s walk through the wrong answer, the right answer, and the part of the Treasury Regulations most practitioners never quote.
The Wrong Answer: “You start counting when the business starts.”
This is the conventional wisdom — and it sounds reasonable:
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For a rental property: you start counting when the property is placed into service.
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For a restaurant: when you open the doors.
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For a consulting firm you purchased: when you take over operations.
IRS auditors say this. Many CPAs say this. Even tax attorneys say this.
But the regulations do not say this.
And in many cases, this answer causes taxpayers to incorrectly conclude they cannot materially participate in the first year of operation — when in fact they can.
What the Regulations Actually Say
Treas. Reg. §1.469-4(b)(1) defines what counts as an activity for purposes of material participation. And it includes three categories of work:
1. Conduct of the trade or business
This is the obvious one: the hours you work after the business is up and running.
This covers:
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Tenant communication in a rental activity
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Hosting guests in a short-term rental
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Serving customers in a restaurant
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Producing goods or services in an operating business
Nothing controversial here.
2. Work performed in anticipation of the activity beginning
This is the critical, widely misunderstood part. The regulation explicitly includes activities “conducted in anticipation of the commencement of a trade or business.”
In plain English: Pre-launch work counts.
Hours spent on:
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Market research
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Property searches
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Drafting a business plan
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Negotiating leases
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Meeting with lenders
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Designing a service offering
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Sourcing suppliers
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Setting up software and systems
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Preparing for launch
… all count toward material participation, as long as they occur in the same taxable year as the business’s commencement (and none of the “throw-out rules” apply).
This is enormously important for taxpayers launching new ventures or buying real estate. (In many cases, it would not be possible to safely and intelligently start a new business without sepdning at least a 100 hours.)
3. Research and experimental activities under Section 174
If your business begins with:
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software development
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product research
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formulation work
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feasibility studies
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experimentation
…those hours also count toward material participation.
This can matter a great deal for tech startups or any venture where the “R&D phase” consumes the majority of the first year.
Does This Apply to Rental Activities? Yes.
A technical point for tax accountants reading this and who have read the regulations. Many people assume rentals are different because the regulations define “rental activities” separately.
But Treas. Reg. §1.469-4(b)(2) simply cross-references the rental activity definition. It does not carve rentals out of the rule allowing:
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pre-operation hours
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hours in anticipation
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research or planning hours
If you’re starting a short-term rental business and spend 200 hours in the spring:
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touring properties
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running revenue projections
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negotiating with sellers
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learning STR software
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analyzing cleaning and maintenance options
… and then place the property into service later that year?
Those 200 hours count.
This can easily push a taxpayer over the 100-hour or even 500-hour thresholds.
Why This Matters So Much in First-Year Loss Situations
Many first-year businesses — including rentals — generate meaningful startup costs, depreciation, and operating losses.
Taxpayers and sometimes even preparers often assume:
“Well, I didn’t start operating until September, so I only have 60 days of hours. I guess I can’t materially participate.”
But that assumption is almost always wrong.
If you spent substantial time preparing the business earlier in the year, those hours often count.
This is especially relevant for:
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Short-term rentals (property acquisition is labor-intensive)
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Real estate flips
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New professional practices
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Restaurants and hospitality businesses
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Software development startups
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Any venture with heavy pre-launch planning
A Practical Example with a Short-term Rental
Let’s look at a really common example where bungling this bit of law occurs. Say Sarah decides in January to start a short-term rental business. She spends:
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120 hours researching markets
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80 hours touring properties
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40 hours negotiating financing
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60 hours setting up software, décor planning, onboarding cleaners
She closes on a property in August and begins renting it in September. Once renting, she spends another 60 hours in operations.
Sarah’s total hours for the year:
120 + 80 + 40 + 60 + 60 = 360 hours
She easily exceeds the 100-hour test and often the 500-hour test depending on further operating activity.
Yet many preparers would mistakenly tell her she only has ~60 hours of participation.
A Few Final Guidelines
To make this all work in practice, taxpayers must do two things:
1. Keep contemporaneous records
A simple log — even in Outlook, Google Calendar, or a notes app — works. But it needs dates, times, and descriptions.
2. Avoid the “throw-out” categories
Reg. §1.469-5T(f) excludes:
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purely investor activities
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hours not customarily performed by owners
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capital acquisition work for someone who will not operate the business
These categories rarely apply to someone who will personally operate a short-term rental or a small business. But they matter for passive investors.
The Big Takeaway
The regulations make it clear: Material participation doesn’t start when the business starts. It starts when you start working on the business — so long as it’s in anticipation of beginning the activity.
For many taxpayers, this means more hours count than they realize. And it means first-year losses are more deductible than they thought, provided they meet one of the material participation tests.
And for short-term rental operators in particular, the hours spent searching for, analyzing, acquiring, furnishing, and preparing a property often form the majority of total participation hours.
That’s good news — as long as you keep good records.
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